One Currency for Diverse Regions: A Balancing Act for Central Bankers

One theme
of this conference centers on the extent to which Europe
will become more integrated, particularly in regard to its
central banking arrangements. Let me make clear up front
that I don't feel that it's my place to lecture Europeans
about what they should or shouldn't do about such important
issues. Nor do I think that there is one model or a magic
formula that a group of countries can follow that will ensure
the success of steps to create a currency union or an economic
trading bloc. Europe's economies and its central banking
institutions will undoubtedly evolve in their own way, based
on their historical foundations and the challenges they
will face in the future.

Europe consists
of a large geographic area that contains a diverse set of
economies that engage in a substantial amount of trade.
The United States is also a large geographic area that includes
a diverse set of regional economies that engage in substantial
trade. Furthermore, the U.S. is an area that uses a common
currency, and now a large part of Europe has adopted a common
currency. Perhaps by telling you about the experience of
the United States in establishing the structure of its central
bank, I can offer you some insights about the challenges
that Europe will face when it addresses changes in its own
central banking arrangements. In addition, learning more
about how the U.S. deals with having one monetary policy
for a diverse set of regions within its borders may be helpful
in understanding the conditions that Europe may face in
the future.

History
of Central Banking in the U.S.

Let me begin
with some history of central banking in the U.S. Central
banking in the United States evolved, it didn't just spring
forth in its current form. Debates about the value of a
central bank have waxed and waned over the more than 200
year history of my country. In fact, the concept of a national
central bank has always been quite controversial in the
United States.

When Congress
in 1791 chartered my nation's first central bank, officially
called the Bank of the United States but now simply called
the First Bank, a major debate about its constitutionality
continued for many years. The First Bank's charter, signed
by our first President, George Washington, was limited to
20 years and the bank was located in Philadelphia.

Critics
argued that Congress had overstepped the authority of the
Constitution by establishing the First Bank, and some state
representatives felt the First Bank, being a federal (or national) bank, was competing with and squeezing out
the banks established by the separate states. The First
Bank's charter was not renewed, and it ceased to exist in
1811. During the next few years came the War of 1812 and
a boom followed by a bust. Despite a continuing debate about
the constitutionality of a federal bank, this period of
financial turmoil led Congress in 1816 to charter a second
Bank of the United States, also located in Philadelphia.

The Second Bank got
off to a rocky start, but eventually became rather influential.
Historians maintain that the Second Bank became very effective
in managing the country's financial system by finding ways
to restrain or encourage the growth of money and credit,
particularly by responding to foreign exchange and trade
flows, which of course were very important when the U.S.
was a young, developing country. But the Second Bank also
had the misfortune of becoming involved in partisan politics
and, as had been the case with the First Bank, its charter
was not renewed.

After the
demise of the Second Bank, some elements of central banking
were then performed by the U.S. Treasury Department. But
the United States was left without a central bank for the
next 75 years.

After a
series of financial panics in the late 1800s and early 1900s,
Congress established a commission in 1908 to examine the
need for another central bank. The head of that commission
studied European central banks before proposing a new central
bank for the U.S. Even with other central banks as a model,
several years of debate ensued before Congress passed the
Federal Reserve Act at the end of 1913. The debate at that
time naturally occurred in the context of the history of
central banking in the U.S. And the debate was just as heated
in 1913 as it had been in 1791 and 1816.

The Federal
Reserve began operating in 1914, and it was built on competing
goals that had to be balanced. Let me discuss some of these
competing goals.

Centralization
vs. Decentralization

In the early
1900s, there were several views of what a central bank should
look like. One view was that a central bank should be highly
centralized. Another view was that it should be highly decentralized.

People debated
whether the Federal Reserve should be located in Washington
D.C. or in New York City. Washington was the center of the
federal government, and New York was the center of the nation's
financial industry. The rest of the country, of course,
was not thrilled with either option. Congress ended up exhibiting
Solomon-like wisdom by putting an oversight body in Washington,
but decentralizing authority throughout the nation by providing
for 12 separate Reserve Banks, including one in New York.
In this sense, the Federal Reserve was truly created to
be federal in nature  just as the founders of the
United States formed a union of 13 separate states that
were part of a federal structure within a national government.
Congress maintained a balance between centralization and
decentralization even when it made major changes to the
structure of the Federal Reserve in the 1930s and formalized
the structure of the FOMC (the Federal Open Market Committee),
which is now the Federal Reserve's main body for making
monetary policy.

When the
Federal Reserve Banks were originally formed, it was with
the idea of operating 12 different monetary policies. Each
Reserve Bank established its own discount rate (the interest
rate at which it provided collateralized loans to commercial
banks), and initially the discount rates in the agricultural
areas of the nation were not the same as those in the industrialized
northeastern region. But it soon became clear that the nation
could not have 12 different monetary policies, because money
and credit flowed readily between regions. The credit markets
were national, not regional, markets. What's more, the buying
and selling of government securities by the individual Reserve
Banks came to be coordinated by a committee in order to
avoid conflicting effects on credit markets. The formalization
of the FOMC in the 1930s as a committee of the seven Fed
Governors and five (of the 12) Reserve Bank presidents was
also a way to balance the regional and central elements
of the central bank.

Public
Interest vs. Private Expertise

The Federal
Reserve as an institution also is a balance between the
public interest and private expertise, much as the First
and Second Banks had been. Congress established the Federal
Reserve as a partnership between the private sector and
the public sector. This structure allows the System to benefit
from private expertise while ensuring that the public interest
is served. This is done in several ways. One is by having
representatives from the private sector serve on boards
of directors that oversee each regional Reserve Bank. Another
is by having advisory councils representing the private
sector meet regularly with Washington policymakers. Yet
another is to have regional Reserve Bank presidents appointed
by the regional boards of directors, subject to the approval
of the Board of Governors in Washington.

Having a
board of directors whose members come from the private sector
has been extremely valuable in running an efficient and
effective Reserve Bank. My Reserve Bank has to deal with
many of the same problems that corporations do.

The benefits
of having private-sector expertise also show up in monetary
policy. Official statistics come out with a lag, so the
Fed can get an early reading on the economy from business,
labor, and community people who serve on its boards. This
information is conveyed to Washington when regional boards
recommend changes in the discount rate. But the discount
rate cannot be changed without the approval of Washington's
Board of Governors, so there remains a central authority
over monetary policy even with this decentralized input.
Meanwhile, the Federal Reserve benefits by receiving a timely
flow of information from the regional boards of directors.

But let
me make clear that there are checks and balances to ensure
that individuals cannot make private gains. The central
bank has strict ethics rules for Reserve Bank directors
and for its officers and employees. Reserve Bank presidents
work under the same ethics rules as do senior federal government
appointees. And we go through security clearance procedures
and background checks, just as they do. And, of course,
Reserve Banks are overseen by the Board of Governors 
a purely governmental body.

Wall
Street vs. Main Street

The congressional
founders of the Federal Reserve provided the central bank
not only with a balance between centralization and decentralization
but also with a balance between Main Street and Wall Street.
By Wall Street I mean financial firms, such as banks and
securities firms. By Main Street I mean the average person
and nonfinancial businesses. The U.S. Congress did not put
the main body of the Federal Reserve in the nation's financial
center, New York; it spread authority for monetary policy
around the nation in 12 Reserve Banks and in the Board of
Governors in Washington. A key benefit of this decentralized
approach is that Main Street and Wall Street are both heard.

Let me give
you an example. The long economic expansion in the United
States during the past nine years has brought down the unemployment
rate. In the early years of the expansion, which began in
1991, many economists in the United States believed that
the unemployment rate could not fall much below 6 percent
without leading to a pickup in inflation. As the unemployment
rate fell below 6 percent, and later below 5.5 percent,
many financial analysts on Wall Street warned that inflation
would soon accelerate.

However,
many businesses  the people on Main Street  were reporting
that they were achieving significant gains in productivity
from the introduction of new technologies. At the same time,
they were reporting that international competition constrained
their ability to raise prices. According to Main Street,
then, the risk that inflation would rise was quite low.
Indeed, actual inflation was declining as the expansion
matured.

Clearly
Main Street businesses and Wall Street financial analysts
had a different view about the inflation risk posed by further
reductions in the unemployment rate.

One of the
things I and my colleagues at other Reserve Banks do regularly
is go out and listen to business people and community leaders
in our regions. During the 1990s, as the unemployment rate
fell even lower and eventually fell below 5 percent, I did
a lot of that. I invited people into the Reserve Bank and
I traveled around Philadelphia's Third District to speak
directly with business people. Most businesses I talked
with expressed the view that fierce competition limited
their ability to raise prices and that improvements in productivity
were helping them to reduce costs and improve profits. Consequently,
I was less concerned about the risk that inflation would
rise simply because the unemployment rate was below 5 percent,
and that affected my views about the appropriate actions
that monetary policy needed to take. My conclusion from
talking to Main Street was different from what it would
have been had I listened only to financial economists on
Wall Street.

The regional
Reserve Bank system allows Main Street's views to enter
policy discussions. Before each FOMC meeting, I make a point
of visiting with groups of business people and community
leaders to get their impressions of the strength or weakness
of business activity. Each Reserve Bank also contacts a
wide range of businesses and prepares a report on regional
economic conditions before each meeting of the FOMC.

I want to emphasize
that information from Wall Street is also important. The
financial system and the real sector both have to work well.
We at the Federal Reserve watch for signs from both.

Accountability
vs. Independence

The Federal
Reserve's structure also provides a balance between public
accountability and its need for independence from partisan
politics.

In a democracy
like that of the United States, the central bank has to
be accountable for its activities. In the U.S., the Federal
Reserve is accountable to Congress and is required to report
to Congress about its actions in a variety of ways. The
Federal Reserve chairman is required by law to testify twice
each year about monetary policy, but Federal Reserve officials
often testify before Congress on a wide variety of other
issues. The Federal Reserve Banks are also audited by an
outside accounting firm, as well as having their operations
overseen by the Board of Governors and, in many cases, by
the General Accounting Office of the Congress. The Federal
Reserve has its own independent Inspector General, whose
findings are regularly reported to Congress. The Federal
Reserve also publishes a large number of documents designed
to keep the public informed of its actions and its deliberations.

On the other
hand, the Federal Reserve's congressional founders did not
want the central bank to become embroiled in partisan politics
the way the Second Bank did in the 1800s. Congress attempted
to insulate the central bank from politics, for example,
by appointing Reserve Board Governors for 14-year terms
and by making the Federal Reserve self-supporting and not
subject to the political pressures inherent in the annual
federal budget process. To avoid making debate about renewing
the central bank's charter a political issue every 20 years,
Congress also eliminated the 20-year limit on the charter
of the central bank. To ensure that the Federal Reserve
remains nonpartisan, the central bank has rules that prevent
its officials from being involved in party politics or holding
political office. And the Federal Reserve's legislative
mandate allows it to make independent monetary policy decisions.

Regional
vs. National Considerations in Monetary Policy Decisions

Finally,
let me comment on the conduct of monetary policy in a country
that contains diverse regional economies. The job of monetary
policy in the United States is to foster an environment
friendly to sustainable economic and job growth  to let
the economy reach its potential without contributing to
excesses. To accomplish this, the central bank seeks to
keep inflation very low. I believe the historical evidence
shows that long-run economic growth is maximized by maintaining
an environment in which there is so little inflation that
expectations of future inflation have little or no influence
on the decisions made by households and businesses.

Although both the
discount rate and the conduct of open market operations
have become more centralized than they were in the early
years of the Federal Reserve, there is still a regional
role in both policy decisions. In discount rate decisions,
the regional Reserve Banks' boards of directors recommend
changes in the discount rate before the Federal Reserve
Board in Washington acts to approve or disapprove them.
As part of this process, the regional directors provide
comments about the performance of the economy, both in their
region and in the nation as a whole, which the Federal Reserve
Board takes into account in making its decisions.

There is
also a regional role in the monetary policy decisions that
alter the central bank's open market operations. All 12
of the regional Reserve Bank presidents participate in monetary
policy discussions at the FOMC meetings, and five of the
12 presidents vote at these meetings. At the FOMC meetings,
the Reserve Bank presidents always comment about their regions'
economic conditions and outlook as well as commenting about
the nation's economic conditions and outlook.

Policy decisions
by the regional Reserve Banks are, of course, influenced
by regional considerations, but they also reflect national
economic conditions. It is understood that the U.S. can
have only a single monetary policy for the country. So if,
for example, some region is experiencing very weak economic
conditions but the national economy is experiencing inflationary
pressures, all of the regions ultimately will support tighter
monetary policy. Of course, in the U.S., low barriers to
labor mobility among its regions and a common language make
this easier.

Nevertheless,
having mechanisms by which the diversity of the regional
economies is recognized in monetary policy discussions has
served the United States very well. Certainly I can tell
you that a system of one central bank with a single monetary
policy for a large geographic area with diverse regions
does work in practice, not just in theory. Indeed, recently
the U.S. has been enjoying a remarkable period of economic
growth. Our current economic expansion is now the longest
in U.S. history, inflation has been quite low, and the U.S.
unemployment rate, now close to 4 percent, is the lowest
it has been in 30 years. Of course, more than monetary policy
has been at work in fostering U.S. prosperity. But a well-functioning
central bank that balances the diverse interests of the
country's many regions has been a positive influence.

Conclusion

To conclude, the Federal
Reserve was built on the need to balance competing goals.
Some of the issues that were debated when the Federal Reserve
was first established still come up in various forms today,
86 years later. Similar debates about balancing competing
goals occurred when our nation first established a central
bank in 1791. Such debates are likely to continue, because
balancing competing forces is part of the ongoing institutional
nature of a central bank. And as U.S. history has shown,
maintaining balance is critically important for a central
bank to function effectively and serve the broad public
interest in a large, diverse nation. I suspect that these
are some of the same issues that Europe will also face from
time to time as it evaluates its own central banking arrangements.